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Rumors of a Hidden Cliff

January 10, 2011

I  invite you to register for our (complimentary and always no-pressure) Protected Index Program® In-Office Seminar to be held at PTI’s Downtown Chicago Offices on Saturday, January 15th, 2011 from 9:00am – 12:00pm. My brother Dan and I will be talking about how the PIP strategy works and fielding questions. Seating is limited but you must register to attend here. I look forward to seeing you there!

Good morning, and Happy New Year. The market started the New Year with a nice gain on the first day, and basically held on to those gains for the rest of the week. The SPY was up 1.39 on the week to finish at 127.14 (up 1.1%), which represents the highest levels since early September of 2008. The VIX was down on the week, closing down 2.7% at 17.13. The VIX, and the volatility levels in the majority of stocks, continue to exhibit a very pronounced skew to the upside as we go out in time. Some of that can be attributed to expectations that interest rates might be expected to increase over time from the current historically low levels, but the majority of the implied volatility skew just seems to be due to “expectations” of increased volatility down the line. It is almost eerie to see that on such a pronounced scale, it is almost like watching an old movie where the wagon train is moving on level ground and everyone is safe for the moment, but next week is the mountains and fog, with the rumors of a hidden cliff.

For retail people that sort of volatility skew is very hard to trade, and it also makes it hard to invest in a protected manner. Investment programs like PTI’s signature Protected Index Program (PIP), that feature constant put protection and defined risk, are based on the option pricing principle that options do not decay linearly but with the square root of time, meaning that the further out in time you go to buy the protective puts the less (in theory) is your cost in terms of dollars per day. That is usually coupled with the “more normal” mindset that the near term news (like earnings, breaking contracts, or monthly sales figures) will cause relatively more volatility in the short term than long. It has been my experience that the “usual” volatility skew in terms of time is for the implied volatility to be flat or even slightly decreasing going out in time. In theory, then, a program like the PIP can “usually” expect the monthly calls sold against the long term puts to pay for the puts in a little less than half the time horizon for the puts. Now that relationship has turned markedly different in a lot of stocks and indices. At current prices the calls are a lot cheaper (in terms of implied volatility and due to the low rates) and will take a significantly longer time of selling to pay for the puts. We have to make sure to not fall into the trap of not staying protected, as the option prices are clearly warning of danger further down the road.

What could be causing, in terms of the thought process of investors, this very odd skew? I have some thoughts, but honestly do not know. My guess is it has something to do with the financial situation of the U.S. government, along with the states and municipalities. I read recently, and reported it on our radio show “Stocks and Jocks,” a Chinese Credit Rating Company of some kind lowering its long term debt rating on the U.S. and referring to “a drastic drop in the government’s intention to repay debt.” Most theoretical pricing models, and most “people’s” individual thought processes, identify information affecting stocks and the markets as a whole as somewhat continuous (like the models are based) but not totally so. What I mean is, everyone knows (including option traders) that the news affecting IBM is not continuous the week of earnings. There is going to be one second where the news affecting the stock is not continuous but very discreet, and the chances of a large movement in the stock price is a lot greater at that particular moment than at virtually any other scheduled event. Therefore the near term options will be priced relatively very high in terms of implied volatility, and will drop as soon as the news is out. Options out two years will not have near the reaction, there will be eight more earnings announcements before they are near term, and the significance of this expected short-term move is less than that on a short-term option. So I must assume that somehow, collectively, people are pricing in some sort of discreet event in the future of a significant magnitude. What is it, or is it just a vague fear?

It could be a fear of some sort of problem with the government’s ability to maintain its preposterous financing mechanism. It should be that people watch the deficits and national debt growing by the day and act accordingly, being more conservative and careful over time. It probably will not happen that way, though, it will be (if it happens) a “sudden” downgrade in the U.S. credit rating, or a “surprise” demand by some foreign country for gold or jets or something for their U.S. paper, not just more paper. Or it could be some country just not showing for an auction, saying not so much that they refuse to finance us but that they want a higher interest rate for the risk of doing so. Is that the cliff in the mountain fog that the wagon train is worried about, or is it something else? It could be the specter of more states like Illinois coming up with a 75% increase in income tax instead of doing their job like real citizens and addressing the problems. Maybe Illinois loses even some more factories, and people that can do their business from anywhere, to the point where the increased tax falls short of revenue expectations, and has to be raised again, and so on. Maybe it will be the strain of bailing out a few states that will be the straw that breaks the Federal house of financial cards. The point is, something, some general concern, is causing this pricing oddity.

The financial fears are surely different in other ways than at any time since I have been in the business as well. When managing money it never was a real problem to be conservative in terms of having cash. It was never ideal to make “only” 3-4% in cash interest when the market might move 7-8%, but it was never fatal either. Now having money in cash is like financial death, not just for lack of earnings, but also for a stated goal of the government, “our” government, to make that cash worth less on the world stage. Historically, that would and should be combated by not having money in cash but in real assets, most notably land and other hard assets. In the last year or two I do not think land was the answer, and maybe not now as well, as the oversupply of residential and commercial properties seems unabated. Commodities have worked to a point, but with the costs of those assets way above production costs, like corn at $6.00, can you stay in or enter here? What about stocks? The problem there is the cost of protection, as we have discussed the relatively high priced of insurance. Not only that, but the last time I checked, when we last deflated our currency through inflation, late 1970’s-early1980’s, the Dow was less than 1,000. A lot of my clients, and a lot of the readers of this blog, are very concerned about the problems right now in having cash balances, and should be. It has me worried.

So what is the market giving us? It is giving us relatively very inexpensive short-term volatility. Those in the PIP program may have noticed an increase in short term trading as we try to take advantage of some of these pricing anomalies. Maybe the danger on the wagon trail isn’t next week or the week after, maybe it is tomorrow. Or maybe we can take advantage of any additional move to the upside if it should happen. I do not like it, in terms of strategy for retail people (or myself) when the relatively least expensive option on the page is the one expiring first, but when it is we have to use our skills to take advantage of it. For new money it may just mean that we buy a few nearer term calls or call spreads to participate in any further move, leaving the bulk of the money in cash. I know cash is not ideal right now, but it can go from not ideal to just what we need if the market were to pull back (as you can tell I am from the school that says having cash available, other than in the Weimar Republic, is never all bad). I also think we need to do a little more investing in the various sectors that we think might be more insulated, like oil, than the general market. If there ever were a significant correction in something like gold I would also consider doing a Protected Strategy in the gold ETF. That ETF does have the physical, and does not degrade over time like a lot of the futures based ETF’s.

It must be obvious that I think 2011 will be a challenge in many ways. I intend to stay protected, given the bumps that seem all to obvious down the road, but I also intend to be a little more diversified in terms of strategies if the historically odd option pricing we are seeing were to continue. Right now the cost of protection is high, but the market is inching up. I do not want to pay those prices for protection, but I still want to be protected, and I want us to participate. It is tough to do all three, but I intend to use my experience to use the lower prices of the near term options to get us to the proper place. It will involve a little more trading, and include some different strategies that are designed to take advantage of lower short-term implied volatility. The game might have changed a little for a while, but we still intend to win, and we have the imagination and determination to do just that. I just hope that we get a little inspired leadership in government at any level before we find that we have already stepped over the cliff.